The next instalment of my Understanding Finance articles based on my Finance For Non-Financial Managers training course looks at how profit is calculated and reported.
This is essential for entrepreneurs, owners of small businesses and anyone managing a business with profit responsibility.
I have mentioned in passing that revenue (sales or income) and costs (expenses) are brought together in the Profit & Loss Account or Statement but I haven't really explained much about the breakdown of these items and how your profit should be reported.
Calculating Profit Is Not As Simple As Adding Up The Transactions
In Matching Costs To Time I explained that certain transactions like the quarterly property rent need to be spread over the three months to calculate the right costs and that sometimes the business will account for the transaction in advance of the cost (a prepayment) or in arrears of incurring the cost (an accrual). I also explained that sometimes revenue has to be spread in the same way.
This means that to get a reasonably accurate measure of your profit, you need to have your accounts prepared by an accountant or an advanced book-keeper.
How Often Should You Measure Profit?
I am glad you asked. If you want to properly manage your business you can't afford to have your profit calculated a few months after your year end. That normally leads to surprises and often they are unpleasant.
You don't want to be in the situation of looking back on decisions and wishing that you could reverse them because you didn't know how bad things were.
Small businesses can get away with quarterly accounts (prepared within four weeks of the end of the quarter) provided the business is very stable but ideally I like to see:
- A set of management accounts including a Profit & Loss Account or Statement prepared every month (and preferably within two weeks of the end of the month).
- Weekly profit estimates based on revenue/sales achieved if the business is under pressure to hit agreed targets with owners or bankers.
I hope you noticed that I set targets for when the information is available to you because you don't want to be looking at your Profit & Loss Account for one period when the next one has already ended. The purpose and value in reporting your profit regularly is that it encourages you to take actions to correct problems and concentrate on any unexpected opportunities.
The Format Of Your Profit & Loss Account or Statement
A key phrase is "monthly management accounts" and this means information that is useful for you and your management team to know each month and which can be used to help you to manage your business.
You do not want a monthly version of your annual accounts which are prepared for the tax authorities and statutory reporting. Unfortunately that is what many firms of accountants will provide unless you specify your requirements in detail.
Analysis of Sales/Revenue
This can be by product category, by customer type (or even by customer), by region (or person) or a combination of them all.
Too often I see accounts with inadequate information provided about how sales are performing when this is the source of all your profit.
If you have too many categories to show on your main Profit & Loss Account, then these can be shown on a separate schedule.
Your Direct Variable Costs of Sale
Sorry about the jargon but I've said before, it is inevitable when we are talking about finance but I will try to make explain as I go along and please leave a comment if I miss anything.
Direct means that the cost allocation is without dispute.
- If you sell books, then the direct cost would be the cost of the books sold.
- If you sell steel components, then the direct cost includes the cost of the steel required to make the component including any scrap.
- If you sell cleaning services, this includes the cost of your cleaners' wages and national insurance/social costs.
Variable means that the value changes with the volume of sales you make.
So if you sell ten books, the cost is twice the cost of selling five books (assuming you don't cross a quantity discount threshold).
Your Gross Profit, Gross Margin or Contribution Margin
Sorry for the different terms but people use different terms for what could be the same measurement and I prefer contribution margin.
This contribution margin is your sales value minus your direct variable costs.
This is an absolutely vital measure to understand because contribution margin is effectively your real income and I like to see it analysed across the same categories as you look at your sales although it can be technically challenging.
Let me try to explain why this is so important.
You may have three different types of product, each selling £20,000 per month.
Product A has a 30% profit margin so generates £6,000 contribution.
Product B has a 15% profit margin so generates £3,000 contribution.
Product C has a 50% profit margin so generates £10,000 contribution.
So if I ask you which is your most important product and the one you want your sales force to promote first, the answer is obviously Product C. It generates the highest profit and every extra £100 of sales generates the most profit.
But what if sales weren't equal?
What if product A has sales of £40,000 per month, product B had sales of £60,000 and product C has sales of £20,000 with the same margin percentages
Now which is your most important product which you should be concentrating on?
- Product B has the highest sales,
- Product A generates the highest contribution at £12k per month (Product B generates £10.5k and product C still generates £10k) and
- Product C has the highest margin %.
This is much closer to the real world where you are having to respond to opportunities by choosing between them but also balancing out how you are going to respond to threats.
There are only so many hours in the day and you and your team need to know where to focus their time for the maximum return.
Having your Gross Profit or Contribution reported by Product / Customer Type / Region means that you can understand what is happening in your business at a much deeper level than normal and you can take the appropriate actions.
Your Indirect Variable Costs
You may have other variable costs which vary with output and sales but which can't be directly allocated to particular products or customers.
Some businesses will find that Labour, Carriage, Power and Consumables fall into this category and for some businesses it is OK to bundle them up and apportion the costs to the product groups on some arbitrary basis.
Other businesses are better to recognise that they need two product margins. The first after direct costs and the second after the indirect variable costs to avoid deceiving themselves.
For example I used to work for a non ferrous metal supplier that identified a material margin (i.e. after only deducting direct material costs) and then a contribution (after allocating direct labour and variable production costs through a complicated calculation based on effort required at each stage of production).
This may seem unnecessarily technical because what you should do will depend on characteristics of your business and your ability to account at the different levels but back in the late eighties and early nineties, big businesses became aware of the damage incorrect cost allocations made to their management decisions.
I will be writing more about the issue of Activity Based Costing some time in the future but it is an advanced financial technique more suitable for bigger businesses.
If the indirect variable costs are comparatively small to sales and direct variable costs, either treatment will make little difference. If indirect costs are substantial, you will need to take advice from your accountants but please have your own thoughts on how they can be allocated and how the allocation may distort your numbers.
Your Overheads / Fixed Costs
These are your fixed costs which are broadly the same for each accounting period unless you take deliberate action.
It includes if appropriate:
1 - Your production overheads
2 - Your distribution overheads
3 - Your sales overheads
4 - Your marketing overheads
5 - Your administrative overheads
In the US, the final categories are often abbreviated to SG&A which stands for sales, general and administrative costs.
Your Operating Profit
The operating profit is the primary measure that you are trying to increase as this is the profit you generate from your business operations.
You may also have other sources of income. For example you may have properties that you rent to other people or you may have sold a property in the year and made a profit on the sale.
To help explain performance from one period to another and from one year to another, I always like to see these unusual items which are not linked directly to the business activity shown separately.
You may also have one off other costs which need to be shown separately.
For example, costs of employee lay-offs and redundancies would distort relative performance comparisons if not they are not highlighted in a separate category.
Interest Payable or Receivable
Your interest will reflect your financing policy (do you borrow from the banks or provide the finance yourself as share capital). While interest is an important cost and should not be ignored, it is best to separate.
Profit Before Tax
A convenient sub-total to show how much economic gain you have generated before the government takes their slice from the company profits. However it is a little misleading since national insurance/social costs and property/local rates and taxes are usually included in overheads.
Company Taxation On Profit
If only death and taxes are inevitable, you should not ignore any opportunities for reducing your tax payable or delaying payment.
Check with your accountant. A big advantage of preparing monthly accounts for profitable businesses is that it means tax planning can be done from a position of knowledge.
Profit After Tax
The profit you keep within your business for the period before any dividends or distributions to shareholders.
This has been a gentle walk through the standard items in your Profit and Loss Account or Statement but if you have any questions (excluding local accounting policies), then please post a comment.
Many of the sets of Profit and Loss accounts I see prepared by professional accountants are:
- Prepared too late.
- Are glorified overhead analyses with no emphasis on the fundamental drivers of profit. It doesn't make sense to have three pages on overhead costs which are relatively easy to control and usually involve a positive decision to incur but only have six lines on the movement down from sales to contribution margin.
I hope that you are now in a position to tell your accountants what you expect to see and if they don't deliver. you may want to read up on my Guide To Finding An Accountant